Brexit - implications for biomass
Jul 04, 2016
A longer version of this article first appeared in Forest Energy Monitor, June 2016
The Brexit vote will have potentially profound implications for biomass markets on many different levels: financial, economic, political and legal. Some of these impacts are known, some are unknowable. Some will be negative in the short term, but others could prove positive in the longer term.
First, the legal ramifications. The Brexit vote itself will have no direct impact on the operation of the UK’s renewable energy policies in the short term. Though the EU has articulated the direction of travel with regard to climate and energy policy within the union, it has never had authority to dictate the energy mix in individual member states, nor the design of the policy mechanisms members choose to employ. Detailed energy policy has always been the responsibility of the individual nations and Brexit will not affect existing entitlements to ROCs or Contracts for Difference.
The longer term legal ramifications are a bit more uncertain, admittedly. Post-Brexit, the UK’s commitments under the EU’s Renewable Energy Directive (RED), for example, can presumably be set aside. But the RED, while important initially, has not been a major consideration in the formation of UK policy in the recent past. Far more influential have been the greenhouse gas emission targets set by the Climate Change Act 2008, a piece of domestic UK legislation that is more ambitious with regard to carbon emissions than anything so far proposed by Brussels.
Under the Act, the UK government sets legally binding ‘carbon budgets’ that determine maximum emissions during sequential five-yearly periods. The latest budget, the fifth, covering the period 2028-2032, requires a 57% reduction in emissions relative to 1990, building on the 36% reduction achieved to date. This was agreed by DECC on 30 June, after the Brexit vote. The timing was coincidental, but DECC no doubt intends that it will shore up investor confidence that the UK’s commitment to GHG emission reductions and to the deployment of renewable energy will continue.
The financial and economic implications of Brexit are more immediate and will disturb the biomass market more acutely in the short term. Financial markets have steadied since the initial shock of the Brexit vote, but the value of the UK pound has been marked sharply lower, by 7% against the US and Canadian dollars and by 5% against the euro.
This will have two effects, first – other things being equal – it reduces the paying capability of Drax, currently the UK’s only importer of industrial pellets. Second, it improves further the cost competitive advantage of European pellet suppliers relative to the North Americans. Even more so than in the recent past, European pellet suppliers will command centre stage in the European spot market, leaving little room for trans-Atlantic merchant supply.
Regarding Drax’s paying capability, factors other than exchange rates also need to be considered. For example, wholesale electricity prices in the UK have been on an upward trend since late April, driven in part by concerns about future supply security in the UK. This increase in electricity prices over the past two months more than offsets the post-Brexit depreciation of the pound. Indeed, our calculations show that Drax’s paying capability today – one week after the Brexit vote – is marginally greater than it was in Q1 2016 despite the recent weakness of the pound.
This is, of course, a short term view. What is of greater interest to wood pellet buyers and suppliers is the future level of exchange rates. What is the new normal? Is the trend rate now $1.35/£ or lower, or will it soon recover to the ~$1.40-1.50/£ band that we had become accustomed to? Also, to what extent will the weaker pound be translated into higher electricity prices? After all, it is not only the cost of pellets that has risen (in pounds); imported natural gas is more expensive too.
The Brexit vote has significantly raised perceptions of political/policy risk in the UK and Europe. It is far too early to predict how UK policy might change until a new UK government is formed under a new prime minister. As always in Britain, much is likely to depend on the personal preferences of ministerial appointees. During the coalition government, successive ministers championed expensive renewables – particularly offshore wind – with scant regard to their cost. Greater emphasis has been given to budget management and competitiveness since the 2015 election, but George Osborne, the Chancellor of the Exchequer and Ms Amber Rudd, the Energy Secretary, have made no secret of the fact that they favour a larger role for natural gas and nuclear as the technologies that replace old coal plants. This implies a lesser role for renewables.
Mr Osborne will not be in the same job after the new prime minister is appointed. Ms Rudd may also be moved elsewhere. This raises questions about the opinions that a new Chancellor and Energy Secretary bring with them. For example, might a greater cost-consciousness cause the abandonment of the troubled Hinckley Point nuclear plant, assuming EDF doesn’t pull out first? Or might there be a postponement of offshore wind projects that are still awaiting approval? Nothing will be known until the new government is appointed.
Given the level of uncertainty, it is understandable that most journalists have highlighted the negative effects of Brexit. In the interests of balance we would like to suggest the possibility of a more positive outcome, for the biomass industry at least. This may not come to pass, but at this stage it seems just as credible as the pessimistic scenarios that have been grabbing the headlines so far.
First, the UK still faces an electricity supply gap. For the 2016/17 winter season, the capacity margin will be around 1%, and possibly negative during certain periods. This supply gap will be perpetuated winter after winter until there is meaningful investment in new generation capacity. But where might this investment come from now? Until the UK’s future relationship with the EU is settled, which could be more than two years away, inward investors may be hard to find.
An alternative source is the UK government itself which is already being encouraged to take advantage of exceptionally low interest rates to invest capital in infrastructure projects of strategic importance, filling a void left by the likely absence of institutional capital. Projects that ensure energy security will surely be on the list. The government is also being urged to retain a foothold in the soon-to-be-privatised Green Investment Bank so that it can direct investment towards projects that support its climate change commitments.
Might a new Chancellor or Energy Secretary, approaching the subject with fresh eyes, look again at the advantages of biomass? The conversion of Drax unit #4 might once again seem a rather good idea, providing 630MW of despatchable low carbon capacity at lower cost – and more quickly – than any other renewable technology. What is more, the UK’s withdrawal from the EU will mean that the state aid rules that continue to thwart the award of the CfD to Drax unit #1 will soon no longer apply.